understanding diagonal spreads

Smart Options Diagonal Spreads

Introduction Many long-time BigTrends customers have asked us why we recently decided to change our Smart Options service from a simple, single-leg option buying service into our new strategy of trading Diagonal Spreads. Frankly, many of you were quite worried, and said you didn’t understand the strategy and that gave you concerns about the risks you might be taking. Perhaps your brokerage firm cautioned you against them also -- if it’s not an options-centered firm, many brokers don’t understand the strategy and therefore declare it “risky”. My goal in this whitepaper is to explain what makes up a diagonal spread; show you the risks (and potential rewards) of the strategy; and help you get your broker ready to execute your trades instead of scaring you -- or help you find a new broker if they won’t. Here’s what we’ll be covering:

1. The Concept of “Income Trading”2. Covered Call Example3. What Makes A Diagonal Strategy Different?4. Comparing stock vs. in-the-money call option5. Constructing the Diagonal6. Exiting the Trade7. Typical Brokerage Requirements

So let’s get started with Understanding Diagonal Spreads

The Concept of “Income Trading” Many new options traders are seriously intimidated by the idea of owning two options on the same underlying stock at the same time, and miss out on all the possible rewards that can come from utilizing options in all of the ways that they can be used. The idea of income trading is not new -- people do it every day. The concept is that you hold an asset of some sort -- think of it as a longer-term asset like a house. But you aren’t fully utilizing it, you aren’t living in the house, and you want to lower your cost of continuing to own the asset.

Understanding Diagonal Spreads © 2010, BigTrends

What can you do? I’m sure you rapidly came to the idea that you could rent the house to someone else and bring in some cashflow to offset your mortgage payments. This is exactly what income trading is all about. Let’s look at the single most common options strategy on Earth for a better understanding -- the Covered Call.

Covered Call Example Let’s say that Mary has 1,000 shares of a stock that she bought a while ago for $50, and that the stock hasn’t moved at all and is recently trading for $50.00 per share. Mary’s considering her alternatives:

Value $ Gain % Change

Skyrocket to $100! $100,000 $50,000 100%

Stock rallies to $54 $54,000 $4,000 8%

1000 Shares @$50 $50,000 break even 0%

Stock drops to $46 $46,000 ($4,000) 8%

Stock imitates a lawn dart and goes to zero $0 ($50,000) (100%) I know which outcome I’m rooting for! Now, obviously the chance of the stock going to zero is remote -- but as we saw in 2008 and again in the “Flash Crash” in 2010, a remote chance is NOT no chance. The covered call is, as we pointed out in our example above, simliar to “taking in a renter” on your asset -- this time, it’s your stock holding instead of your house. The way this works is:

● You sell a call option on the same underlying symbol as your desired stock● The income you bring in by selling the call option lowers your cost basis on the

stock. This also has the effect of lowering your break-even point if the stock should subsequently sell off.

● You already own the stock, so you don’t need to do anything with it Note that if you don’t currently own the stock, you can buy it at the same time, in the same transaction. It results in the same position. Some brokers call this a “buy-write” instead of a covered call because you’re doing both transactions simultaneously. Let’s look at it like we did the stock trade, but this time, we’re going to sell a call option with 40


days until expiration at the $55 strike price, bringing in $1.50 per option. When we say that we bring in $1.50 per option, remember that there is an options multiplier (typically 100, as in 100 shares of stock) that we have to multiply the option value by. So if we sell the option for $1.50, we bring in $150.00 per option.


Since we own 1,000 shares of the stock in this example, we can sell 10 contracts in this “covered” example -- the stock “covers” the short call’s potential risk to your brokerage firm.

Stock Price Stock P/L Short CallP/L

Combined Net P/L (@expiration)

$60 $10,000 ($3,500) $6,500

$55 $5,000 $1,500 $6,500

$50 breakeven $1,500 $1,500

$48.50 ($1,500) $1,500 $0

$45 ($5,000) $1,500 ($3,500)

$40 ($10,000) $1,500 ($8,500)

$0 ($50,000) $1,500 ($48,500)

As you can see here, that income that you bring in from selling the short call caps your maximum possible gain, but provides some downside protection as the stock drops. How much downside protection? The amount that the call is sold for -- $1.50 per option. So with the stock at $50 per share, minus the $1.50 we sold the call for, our new, lower breakeven price is $48.50 per share!


Risk Diagram

Image courtesy of trademonster This image above shows the risk and reward graph of the covered call, with the stock price on the horizontal axis and the profit/loss in dollars on the vertical axis.

RisksIn either of these cases, as you can see from the tables above, you have to be at least moderately bullish on the prospects of the stock. If not, the best trade is to exit the position entirely. The income you bring in provides a small amount of downside protection, but does not insulate you from a big downside move.

RewardsCovered Call trades can bring in additional income if a stock stays in the same place or rallies. But those gains are capped once the stock starts trading above the strike price you’ve sold. In our example above, if the stock goes nowhere -- just stays at $50 a share -- you keep the $1,500 for the sold call. Divide that $1,500 into the $50,000 that the stock holding is worth, and you can see that for about a month and a half (40 days), you have a 3% return. Huge winner? Nope. But a consistent trade that works well in slowly upward grinding markets (or stocks), and you can do it month in, month out.


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Special NotePAY ATTENTION -- this is the most common mistake new options traders have! You want the stock to trade up to the strike price. You don’t want it to drop. It’s OK if it stays in the same place, but you’re still in a bullish position. And if it shoots way up and through your strike price, you’ll have to console yourself about the gains that might have been with the gains you actually have in your pocket. (I’ll try not to cry you a river.) Around this point, you’re probably muttering to yourself, “so when is this guy going to talk about Diagonal Spreads, exactly?” Right now! Turn the page...


What Makes a Diagonal Spread Different? I’m sure that all the explanation of the covered call was review for many of you. What does this have to do with diagonal spreads, you ask? It’s simple: a diagonal spread is simply a covered call -- but you exchange the stock holding for a longer-term option. In the case of the Smart Options newsletter service, BigTrends uses a deep in-the-money (ITM) in place of the stock. We choose these options because they move more like the stock will than an at-the-money (ATM) call option would. In options parlance, ITM options have a higher delta than ATM options. This simply means that when the stock moves up or down by $1.00, these ITM options will move more than the ATM options will. If we look at a simple exchange of the stock for an option expiring roughly 6 months from the time of this writing, and find a delta higher than 70%, it leads us to the $42 strike price, expiring in March ‘11. This option is quoted at about $6.50 per option.

Comparing Long Stock with a Deep-In-The-Money Call OptionLet’s just compare the stock against the new long option: Cost Max Gain Max Loss

Long 1000 shares at $50 $50,000 infinite $50,000

Long 10 contracts at $6.50 per option $6,500 infinite $6,500


Here’s how the long option looks on a risk graph:

Image courtesy of trademonster ...and since the options will gain 70¢ of the next $1.00 gain in the stock (and each $1 thereafter, a little more than 70¢), this seems to be substantially better utilization of your trading capital, with one exception: If this is a stock you intend (or are required) to hold for a very long time, then owning the stock is a better alternative.

Speaking Diagonally...Let’s recap what we’ve covered to this point, and then we’ll tie it all together.

1. Covered Calls give an equity investor the ability to bring in immediate income on their stock or ETF holdings. In our example above, roughly a 3% yield was demonstrated.

2. A deep in the money call behaves very similarly to (but not exactly like) a stock position.3. A Diagonal Spread uses a deep-in-the-money call option as a substitute for a stock (or

ETF)



So what does this thing look like when we pull it all together?

● We’re still going to sell the Dec 50 call option for $1.00● Instead of buying the stock for $50 per share, we’re buying the Mar 42 call for $6.50

Buy Mar 42 call $6.50

Sell Dec 50 call ($1.00)

Net debit for diagonal spread $5.50

Options Multiplier (100 shares per contract) $550 per spread

[times] 10 contracts (ea.) to equal 1,000 shares $5,500 total risk The same information, shown another way in the snapshot analysis:

Image courtesy of trademonster From the snapshot overview of the position, you can see here that the highest potential profit for this trade happens at December expiration, and if the stock happens to be trading right at the strike price of the short option ($50). If we were to hold it that long, there is a theoretically possible 62% return on this trade instead of the 3% that we had with the covered call.



So...62% vs. 3%. Why no exclamation points? Why no huge bold text saying “WOW!”? Because this is extremely unlikely to happen. The way that BigTrends views these trades is that if we can get a 20-30% return, we’re going to take the profits, exit the trade, and look for another opportunity. When might that be possible? Let’s take a look at the very cool Spectral Analysis tool that online broker tradeMONSTER has with this trade and see what it can show us.

Image courtesy of trademonster



In this example, instead of the simple analysis we have been looking at throughout the paper, we can “what-if” every combination of stock price, volatility assumption, and date between today and the expiration of the short call. The top image actually plots nearly 30,000 data points and shows them all in a nice red to green image showing us where our potential profit and loss is. We can see that if this stock retests its mid-October highs by mid-November and returns to $48.24 per share (from the $45.74 you can see it is currently trading at in the top right corner), we would be looking at roughly a $1,400 profit, or 25% gain compared to the $5,500 invested. Also, note in the bottom left of the image, our breakeven point on this trade is approximately $44.50, so we have some downside protection on this trade as well.

[Ed. Note: What’s not shown in the screenshot is that this tool also will let you change the volatility assumption and see what happens to the trade when volatility goes up or down -- a great educational tool. If you’d like to check it out, visit tradeMONSTER’s website. They let you open an account without funding it, and have a $50,000 paper trading platform to let you practice and see how you like it.]

Exiting the TradeOne important note is that you should put the diagonal on and take it off as a package, on one order ticket. If you enter the trade with 10 contracts, you might take a few of them off and leave the rest a little longer. But don’t buy back the short calls and leave the long call on unless you’re rolling that short call to the next month. And you should only do this because the chart is telling you it still makes sense -- not just because the trade worked out the last time you tried it!

Typical Online Brokerage RequirementsSo what do you need to be able to trade these strategies in your typical online brokerage account? The unfortunate truth is that it varies from broker to broker. I spent many years in the brokerage business, and I can attest that in spite of what people think, the vast majority of people working in the brokerage business do not understand anything about options and how they work -- unless they have specialized in them. But there are options-intelligent brokers out there who understand these instruments and understand that limited risk trades are just that -- limited risk. Often, they’re lower risk than owning the stock. The risk of the trade we’ve examined in this paper is absolutely limited to the $5,500 you invest in it. There is no way for you to ever lose more than that. Even if you woke up tomorrow morning and the stock has “pulled an Enron” and opened at zero. Given that, trading these strategies isn’t solely appropriate for speculators -- you can do these









trades in your retirement accounts -- IRA’s, Keogh’s, PSP’s, whatever. The trick is finding a broker that will let you. As of the time of this writing, we believe that this strategy is permitted in both brokerage and retirement accounts by:

● tradeMONSTER ● ThinkOrSwim● optionsXpress● Trade King

Yours may also allow you to trade diagonals, although you may have to fill out an options authorization form to do so.

If your broker tells you that you have to trade a certain number of any other strategy (covered calls, buying single options, etc.) before you can trade these lower risk strategies, IT’S TIME TO FIND ANOTHER BROKER, one that treats you like an adult. Any of the firms above are fine places to start your search.

Wrap UpBetter utilization of your trading capital, higher probability of winners, and superior returns compared to covered calls. Diagonal spreads have many situations where they can succeed and BigTrends’ Smart Options allows you to pair this options strategy with the solid technical analysis and stock picking skills that the BigTrends Research team uses every day on behalf of our subscribers.




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understanding diagonal spreads

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